Finding Your Economist Soulmate

By Megan McArdle -
Aug 20, 2013

The activity of the day among economics bloggers is this site, which allows you to answer questions about the economy, and then tells you what economist you are most similar to (based on their responses to IGM’s surveys on economic issues). It turns out that I am most similar to is Anil Kashyap of the University of Chicago, which is not entirely surprising, because I’m a big fan of Kashyap’s work on things like Japan’s 20-year “Lost Decade”.

This paper analyzes a model where investors use a credit rating to decide whether to finance a firm. The rating quality depends on the unobservable effort exerted by a credit rating agency (CRA). We analyze optimal compensation schemes for the CRA that differ depending on whether a social planner, the firm, or investors order the rating. We find that rating errors are larger when the firm orders it than when investors do. However, investors ask for ratings inefficiently often. Which arrangement leads to a higher social surplus depends on the agents' prior beliefs about the project quality. We also show that competition among CRAs causes them to reduce their fees, put in less effort, and thus leads to less accurate ratings. Rating quality also tends to be lower for new securities. Finally, we find that optimal contracts that provide incentives for both initial ratings and their subsequent revisions can lead the CRA to be slow to acknowledge mistakes.

And here’s why I like Kashyap’s work: like most people, I would have easily and quickly identified the problem with having companies pay for their own ratings. But I wouldn’t have instantly thought of the problems with alternative possible systems. If our judgments on recent economic issues are similar, I’m in good company.